Commentaries

As we take a look back at 2014 (and ‘13, and ‘12, and…), we see a wake of volatility that continues to this day, even if the direct causes of volatility may have changed. Geopolitical uncertainty, economic instability, natural disaster; all have affected the markets, and what stands out to us is the amount of incidents this year, and how quickly things change. Mid-summer, Vladimir Putin’s belligerence seemed unstoppable (remember Crimea?). Now Mother Russia is in the early stages of what could be a deep and prolonged recession. It is by far in the worst shape of any of the BRIC countries (Brazil, Russia, India and China). A smattering of other global surprises that could not have been predicted (because either few had heard of them, they haven’t occurred since the 1970’s, or they didn’t exist), were Ebola outbreaks, sub-$50 oil, ISIS/ISIL, and US urban (and suburban) rioting.

Some of the reasoning for the extreme gyrations of the last few years has to do with direct political upheavals (some of which we will address further on), while some pertains to ubiquitous fiscal maneuvers, particularly the actions combined under the (fairly) recently coined term “Quantitative Easing” or “QE.”

Putin’s Russia relies dearly on high gas and oil prices, as these exports account for approximately one half of federal budget revenues (as well as acting as a cudgel when he threatens to withhold supplies from those who dare say nyet to him). Prices are falling, and the supply lines are shifting. Russia has one of the highest price-per-barrel extraction costs of any exporter, and Putin needs to see prices near $105/bbl to balance his budget. As prices fall, the world’s largest energy exporter faces increasing competition. Prices today hover in the mid-$40 range and the ruble has fallen 50% vs. the dollar. This could have unintended consequences of its own, and it’s uncertain how Putin may react. So far -this is true- he has only come up with price controls on vodka. Stay tuned for what happens after the hangover wears off.

As for the rest of the BRICs, Brazil has suffered from a continued hard-left socialist turn by Dilma Rousseff, who has changed many of the successful reforms and programs of the “soft” left Lula da Silva, whom she succeeded as President in 2011. In a very close October 2014 election, Rousseff won in a tight contest, re-elected receiving 51% of the vote while running as a populist against the center-right reform candidate Aécio Neves. This caused what had been a hopeful market’s benchmark BOVESPA to plunge 20% from its pre-election highs, reached with the hopes of a change in government. Inflation remains damagingly high to the consumer society, under the administration’s hope that it will help keep employment high. Brazil’s largest company (and a former holding) Petrobras, remains mismanaged under state control.

Much of the anticipation that led to the short-lived increase was influenced by India’s market, which received a positive jolt after the spring elections led to a change in government with the economically astute Narendra Modi being elected as Prime Minister. The margin of victory was such that his party gained an outright victory, and therefore no need for a coalition government. India’s government is often divided and mired in a bureaucratic state of suspension. Such a clear political victory, for the reform candidate no less, has encouraged investors the world over. The hope is that he can do for the Indian economy as a whole what he accomplished as the longest serving Chief Minister of the state of Gujarat from 2001-14. He was able to greatly increase economic growth (roughly 10% a year), improve and expand infrastructure, and cut through the famously byzantine and glacial-moving Indian bureaucracy. If he can transfer his successes to a national platform, it is likely that India’s surprises will be to the upside, and return GDP growth, 4.7% for 2013-14, back to the levels achieved in the second half of the last decade, when it ranged from 7.9% to 10.3%. So far the results have been positive, and the outlook remains positive. A notoriously bureaucratic system appears to be accepting his position of leading a change, and 80 % of the population - one billion people - not currently in the middle class stand to benefit.

China continues to confound the panda-bears, who have gleefully been predicting a collapse for a decade. GDP growth has indeed slowed from what were unsustainable double-digit numbers, and expected to settle into a 6.5%-7.5% range, still one of the highest of any country (earnings continue to compound at double-digit rates). The economy appears to be successfully transitioning from one that is export based and centrally planned to one that is consumption based and driven by market forces. Now the world’s largest economy (based on International Monetary Fund [IMF] GDP purchasing power parity estimates), it would and should be expected that there will be bumps, sometimes major, along the way. We have discussed China at great depth in the past (and will certainly do so in the future), as it is a vital cog in the global economy, whether you consider that for good or for bad, and whatever your political views may be.

Go East, Young Man

Asian economies currently play a large part in Pendo’s overall strategy. Companies based in China, Hong Kong, India and Singapore makeup roughly 2/5ths of the portfolios composition. We will discuss a few, although there are many reasons for this, all leading back to where we find the best value combined with the best environment for economic growth.

There is a general Pan-Asian movement to reform government. The underground economy is becoming more controlled; the rule of law is being more firmly established and upheld. What once were centrally planned economies, or relatively tiny economies that might withstand an amateurish oversight from an authoritative regime, have now become more developed, vital and most importantly, more open. All this is in an attempt to modernize and grow their economies, and to be able to attract foreign investment and compete more fully on a global level. Instead of apparatchik appointments, central banks are being run by world-class central bankers. One of the most respected in the world today is India’s Raghuram Rajan, who earned his PhD from MIT and is on leave from his professorship at Chicago’s Booth School of Business. He is also the former chief economist at the IMF. In economic nerd circles, he is a rock star.

Asian middle class incomes continue to grow at a higher rate than more developed economies. Unlike most of the developed world, there is a higher percentage and concentration of income growth in the middle and lower class than in the upper 10%, and a more even distribution of wealth than the US, where the oft-discussed “wealth gap” between the “99%” and “1%” has actually widened since its introduction as a political issue along with the beginning of the economic recovery.

These economies all depend heavily on natural resources, energy among them. The recent severe drop in materials and energy prices is a (near term especially) gift, helping not only to slash the cost of output, but provide a savings to the consumer that translates to an increase in disposable income. It is also enabling these growing economies to stock up on supplies of commodities at low prices, in advance of an inevitable increase in prices.

Governments have also taken a more proactive approach to fixing their economies. Even those who have resorted to some sort of stimulus have come nowhere near the level of sustained interference that western economies have resorted to. Education is improving, increasing the skill level, production levels, and helping them to transition to higher-paying and higher-margin service economies. China has already made concerted efforts via price reforms to prevent a catastrophe should real estate prices tank, while the US government has recently loosened requirements on mortgages, to encourage first-time buyers who might not have previously qualified. Remind us, what was a main contributor to the last crash (that we have yet to fully recover from), less than a decade ago?

Asia overall continues to have a very high savings rate. This not only serves as a cushion in economic downturns (versus a highly leveraged west), but as incomes rise and social safety nets are set in place, it serves as a base for even more disposable income. In the larger sense, countries with a higher savings rate are more poised for growth and investment, without having to rely on foreign investment.

These are a few factors that have helped to begin a shift of the world’s economic activity away from the last century’s powerhouse and back toward the powerhouse of the previous two millennia. The regional nations are quick to take advantage of this shift, and have begun forming alliances not just among themselves, but with some of the western hemisphere as well (Latin America in particular), where some trading that no longer involves the US is also no longer traded in dollars. Seizing on this, China has formed a competitor to the World Bank’s Asian Development Bank (as well as the IMF) with its own Asian Infrastructure Investment Bank, and has already given direct aid to several countries. Officially chartered in October of 2014, 21 developing countries signed on. Regional developed-economic heavyweights Australia and South Korea, after expressing serious interest, were dissuaded from joining as founding members by the US. Not all of the member countries would by any means be considered “friends” of the United States; clearly the balance of power is not only shifting but being fought over. Who will be most up to the task?

The Pendo Methodology

Our goal is to always buy undervalued securities, and hold them until they reach their fair value. Since our companies have solid fundamentals (discount to intrinsic value, solid ROE and EPS multiples, etc.), and since we have had very low turnover, there is no rational explanation as to why we have been so undervalued for so long, other than perhaps we arrived too early to the party. In any case, we were glad to be “welcomed” this year, since last year we were certainly given the cold shoulder.

Pendo is a long-term value investor, and invests in individual businesses as such. Our methodology is to identify solid, profitable businesses with consistent earnings growth and a competitive advantage. When we do, we ask ourselves, “If we were buying one business to run as our own enterprise, would we be comfortable owning this particular one?” If the answer is “yes,” we then ask if it is for sale at a fair price. If it is, we are not interested. We will continue to watch it to see if it is ever trading at what we consider to be an appropriate discount to intrinsic value. This may be because of a temporary price dislocation due to the market’s confusion or misunderstanding, the business for some reason has temporarily fallen out of favor, or a distressed seller.

While we focus on the long-term, governments partake in various short-term Quantitative Easing schemes (which under any other name would be known as short-term central planning). QE is a deliberate measure meant to prop up markets for the time being and then hope that longer-term economic forces reach equilibrium in time to carry the markets on their own (what we used to call a “free market”), before the invasive and unintended consequences have a chance to unfold.

We cannot guess when this will end, nor do we try to surf the artificial tide. We are investors in businesses, not traders in momentum or trend. There may be temporary disruptions caused by government intervention, and longer-term disruptions caused by new technology, which seems to have shorter and shorter life cycles these days.

As long as we continue to hold companies that grow and benefit from continuing business cycles, and as long as we continue to buy companies in “necessary” businesses that cannot be made obsolete by the latest high-tech breakthrough, we should not suffer permanent pain from temporary dislocations and will be protected from longer-term disruptions.

In times of uncertainty, we stick with the fundamentals even when it may be temporarily out of favor. We wish to hold companies that are not necessarily correlated to the momentum of market moves which may be based on short-term sentiment (sentiment that causes moves in markets, and even individual companies, of + or – 1 or 2 percent per day in either direction; sometimes several days in a row). Eventually, people will seek and discover the undervalued, especially if it is the “better mousetrap.”

We generally say “yes,” it is old-fashioned. We also believe it is the most tried-and-true, up-to-date and effective way of slowly building long-term wealth. We are confident in the long-term of a mean-reversion; that people will always want to return to owning a sustainable business that creates wealth for the long haul.